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Margin Trading Explained

Margin trading is a facility provided by members of stock exchanges to their clients to leverage their short term investments in the secondary markets, by providing a borrowing facility for funds. It allows investors to take a larger position than what their own resources would allow, thus increasing their profits if their expectation of price movements came true.

The adjacent image explains the concept of margin trading. You can get another perspective of Margin Facility in India here.

Stock brokers offer the margin trading facility to their clients who enter into an agreement with them. The agreement specifies the initial and maintenance margins to be maintained and the cost of funds. The stock brokers specify the stocks on which the facility is available.

Typically, stocks with high liquidity and trading volumes are selected. Investors use the margin trading facility to take short-term position in stocks.

Margin calls are triggered when a fall in the value of the stocks reduces the net value of the portfolio (value of stocks less borrowed funds) and makes it necessary to bring in additional funds or securities to meet the maintenance margin specified. The broker (lender) retains the right to liquidate the position if the requirements are not met.

Margin trading amplifies the loss to the investor in the event of adverse price movements. Higher the leverage used i.e. proportion of borrowed funds to own funds; greater will be the loss to the investor. A margin call will require the investor to bring in additional funds at short notice, which may or may not be possible. In the event funds are not brought in, the investor stands to lose the securities since the agreement which they enter into with the stock broker (lender) allows the lender to liquidate the stocks partially or fully to make up the funds required.

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